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Morgan Stanley to Traders: Knee-Jerk Fed Chair Move Won't Last

President Donald Trump is expected to announce his pick for the next Fed Chair on Thursday.

By Brian Chappatta

(Bloomberg) --However the bond market reacts to President Donald Trump’s nominee to lead the Federal Reserve, Morgan Stanley has some simple advice: do the opposite.

Whether it’s Fed Governor Jerome Powell, the favorite in betting markets, or someone else such as John Taylor, Kevin Warsh or Janet Yellen, the knee-jerk move in Treasury yields won’t last long, according to Matthew Hornbach, Morgan Stanley’s global head of interest-rate strategy. He recommends fading the initial reaction to each of them within the first month. If Powell gets the nod, do it in the first week.

It’s a bold wager for investors to make after a decision that could influence the direction of monetary policy for years to come. But it speaks to how the $14.2 trillion Treasuries market is at a crossroads, with the benchmark 10-year yield fluctuating around 2.4 percent. Some said a significant breach above that mark, like that which happened last week, would spell the end of the bond bull market. Yet in the span of five trading days, others now see signs of a rebound.

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“It takes more than just a change in the Fed chairmanship to get interest rates to trend in one direction,” Hornbach said in a interview. “What I’m trying to get across in fading every knee-jerk move in the first month is simply that there’s a limit to what the Fed chair can engineer over the course of his or her tenure.”

“If the market overreacts in that first month -- which markets tend to do from time to time -- you’re supposed to take the other side,” he said.

Leading Contender

Trump plans to announce his Fed chair pick on Thursday, according to a White House official. Betting website PredictIt has Powell as the leading contender at 84 cents, with Taylor a distant second at 7 cents. Morgan Stanley predicts Treasuries will rally on a Powell nomination, with the 10-year yield trading in a range of 2.3 percent to 2.4 percent the following week. The rate would do the opposite with a Taylor pick, increasing to between 2.5 percent and 2.7 percent, according to Hornbach’s forecasts.

Lost in the hoopla over the next Fed leader is the Federal Open Market Committee’s Nov. 1 interest-rate decision. Traders aren’t expecting much of a surprise, though policy makers could more directly acknowledge that inflation is running below their target. 

Other than that, officials will likely aim to confirm that the market is right to imply an 83 percent probability of a hike in December, based on overnight index swaps and the effective fed funds rate.

“The Fed will leave the door very wide open for a hike in December,” said Matt Toms, who oversees $133 billion as chief investment officer of fixed income at Voya Investment Management. “The market won’t go to 100 percent, but they’ll tell the market that they have the 80 percent expectation correct.”

Fed Projections

Another rate increase in December would mean the Fed stayed true to its projections, after only tightening policy once in 2016 despite calling for four quarter-point hikes at the start of that year.

To Hornbach, Powell or Yellen would be expected to hike three times in 2018, in line with the central bank’s current “ dot plot.” Yet the market would only imply about two moves after their nomination.

By contrast, analysts would expect Taylor to raise rates four times, and traders would price in somewhere between 2.25 and 3 moves.

At JPMorgan Chase & Co., Jay Barry said he sees yields rising more than forward contracts suggest next year, led by the front end. He’s neutral on adding interest-rate risk for now.

The bond market is “able to price in more Fed tightening than it has in the past,” Barry, a fixed-income strategist, said in an interview.

 

--With assistance from Elizabeth Stanton.To contact the reporter on this story: Brian Chappatta in New York at [email protected] To contact the editors responsible for this story: Benjamin Purvis at [email protected] Boris Korby

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